Friday, September 26, 2008

Intrade state-by-state joint dynamics

There is a wealth of available information on the presidential race -- national and sate polls; poll aggregators like RCP; and meta-analysis like that being done at fivethirtyeight.com and others. And of course there are prediction markets. The Intrade markets on the presidential race (by party or individual) address the question of who is winning directly, but looking to them alone ignores all the information in the state-by-state market prices.And it is the state races, ultimately, that decide the winner.

Investigating the joint dynamics of these 51 individual state markets on Intrade gives a complimentary – and perhaps ultimately the clearest -- picture of how the race is going.

Fundamentally, the problem is similar to risk management of a portfolio. From the candidate's viewpoint, they have a portfolio of 51 binary pay-off assets with fixed weights as determined by each state’s number of electoral votes.

Each state race has a characteristic volatility. And critically, each state is correlated to every other state. These attributes can be empirically determined by Intrade’s historical state-by-state market prices.

Then, we can use the standard technique in portfolio management – to build up a picture of the portfolio dynamics by simulating (out to election day, in this case) correlated series of returns on each individual asset.

By repeating the simulation many times, we get a probability distribution of the expected outcomes. In each simulation, in each state, if the Republican price on Election Day is greater than the Democratic price, the electoral votes are awarded to the Republican, and vice versa.

I’ve run the simulation 5000 times, and found a very interesting distribution of where the electoral vote tally might end up – as implied by the Intrade markets.

As of Sunday September 21, even though national polls are coming in close to 50/50 and Intrade’s contract for Obama to win the Presidency is trading close to 50, Intrade's state-by-state traders implicitly believe Barack Obama has a 76.8% chance of winning at least 269 electoral votes and thus the presidency (I assume a 269-269 tie will be awarded to the Democrat by the new House of Representatives).

How does this fit in with the presidential market prices, which indicate a much closer race? That’s a good question, and I hope to hear some interesting suggestions. Here are some thoughts on:

Obama was winning 273 electoral votes on Intrade on September 21, and so we might expect that to imply a chance only slightly greater than 50% of victory.But Nevada (5 EV), Ohio (20 EV) and Virginia (13 EV) were all less than a 5 point lead for McCain while McCain's likeliest flip was Colorado (9 EV) at 56-44.Because Obama has a better chance of flipping some of the slim McCain leads than McCain does of flipping anything into his column, my simulation’s skewed toward increasing Obama’s total from 273.While 273 is the most likely outcome for Obama’s EV count, the mean was 283.